Three essays on banks' relative efficiency
Three Essays on Banks’ Relative Efficiency Jorge Guillén Dissertation Submitted to the College of Business and Economics at West Virginia University in partial fulfillment of the requirements for the degree of Doctor of Philosophy In Economics Santiago Pinto, Ph.D., Chair Stratford Douglas, Ph.D. Alexei Egorov, Ph.D. Ashok Abbott, Ph.D. Arabinda Basistha, Ph.D. Department of Economics Morgantown, West Virginia 2006 Keywords: Data Envelopment Analysis, Stochastic Frontier Analysis, Riegle Neal Act, Nonperforming Loans Copyright 2006, Jorge Guillén UMI Number: 3276508 3276508 2007 UMI Microform Copyright All rights reserved. This microform edition is protected against unauthorized copying under Title 17, United States Code. ProQuest Information and Learning Company 300 North Zeeb Road P.O. Box 1346 Ann Arbor, MI 48106-1346 by ProQuest Information and Learning Company. ABSTRACT Three Essays on Banks’ Relative Efficiency Jorge Guillén Three separate studies are conducted regarding banks’ relative efficiency. Previous to start with the development of the studies, we review the situation before and after the enactment of the Riegle Neal’s. This act restricts banks from opening branches in another state. The Riegle Neal act ended up the era of state branching deregulation which started in 1970. A discussion between proponents and opponents of branching deregulation is presented. A debate between bank’s efficiency and concentration before Riegle Neal is introduced in the chapter. The first essay found in chapter 2, develops a theoretical model of spatial competition between banks. Two different scenarios are considered. The first one assumes that banks cannot open a branch or a subsidiary in another region. The second scenario assumes that there are no branching restrictions. We derive the Nash Equilibria and determine winners and losers in each case. Moreover, we study whether the incentives to open a branch are affected when the cost of performing long-distance transactions decreases, as evidenced in the banking sector. The model is able to explain who benefited from the branching restrictions implemented in the U.S. in 1927 and why this law was then eliminated in 1994. Chapter 3 contains the second essay. It addresses the effect of banking and branching state deregulation on banks’ efficiency. The Riegle Neal Act of 1994 concluded the process of state deregulation which started in 1970. In this paper we calculate an indicator of bank efficiency using Data Envelopment Analysis (DEA). The efficiency indicator is used as the primary input to analyze the effect state branch deregulation on bank’s efficiency. In addition, a failure prediction model is carried out using these efficiency indicators. Size and regional allocation effects for banks are considered in the paper. Chapter 4 contains the last of the three studies. We test the validity of different hypotheses commonly employed to explain the proportion of non-performing loans held by banks. Particular attention is devoted to establish the link between efficiency and the share of non-performing loans. Based on the results of causality tests, our empirical analysis suggests that the Moral Hazard, Bad Management, and Skimping Hypotheses can still explain the proportion of non- performing loans for each bank size during the last ten years. The result complements the study of Berger and DeYoung (1997). iii To Katy and Sebastian iv ACKNOWLEDGEMENTS I am greatly indebted to my advisor, Santiago Pinto and his patience and remarkably guidance during these four years in the PhD program. He just helped me turning my ideas into a dissertation. He always had some time to read carefully my papers and provide invaluable ideas and suggestions. He always gave me personal advises besides his guidance toward the completion of my doctoral degree. I should express gratefulness to the remaining members of my dissertation committee, Stratford Douglas, Mehmet Tosun, Arabinda Basistha, Alexei Egorov and Ashok Abbott. I just really appreciate their help and time. Many thanks go to my professor and colleagues in the Department of Economics. A special recognition goes to Ellis Heath for his help in the final edition of my dissertation. My sincere gratitude to my parents, Alfredo and Adriana for tried their best raising me. My family’s support alleviates the stress I have been through this period of time. I also thank to my brothers and sister for their support. My special recognition goes to my brother Carlos. He has been an important master piece in the completion of my education. I would like to extend the thanks to my friends Robert La Porte and Trace Gale for their friendship. They make my stay in Morgantown very pleasant. I also appreciate the guidance of Cesar Fuentes, Javier Illescas and other Peruvian and Spanish Economists that encouraged me to finish my professional goals. I just can not list all of them at the same time but my sincere recognition to them. Finally, I want to thank the most important person in my life: my wife Katy. I thank her for being very patient during these years. She helped me by spending many hours encouraging me to finish my goals. She amazingly completed two masters during our stay in United States and now she is giving me my first son: Sebastian Jorge. We have passed through some personal difficulties but besides that, we have been able to overcome everything together. Any errors are the sole responsibility of the author. v Table of Contents ABSTRACT ii ACKNOWLEDGEMENTS iv Chapter 1: Introduction to the Three Essays on Bank’s Relative Efficiency 1 1.1 Introduction 2 Chapter 2 :Review of the situation before and after the enactment Riegle Neal’s 4 2.1 The History before Riegle Neal Act 5 2.2 Opponents and the Proponents of Branching 6 2.3 The attempts to avoid the restriction on branching 7 2.4 The path to the deregulation 9 2.5. The Riegle Neal Act of 1994 10 Chapter 3: Spatial Competition between Banks: A Theoretical Model 12 3.1. Introduction 13 3.2. Banking Deregulation: Brief Historical Review 16 3.3. The Model 18 Table 3.1 The Consumer Payoffs with branching restrictions 19 Table 3.2 Consumer Payoff in Scenario II without branching restrictions 20 Figure 3.1 Extensive form representation of the game. 20 3.4. The Model with Identical Costs 21 3.4.1. Scenario I: bank 1 operates in A and bank 2 operates in B 22 3.4.2. Scenario II: bank 1 opens a branch in region B 23 3.4.3. Comparing the results 24 Table 3.3 Summary of Results: c1 = c2 = 0 24 3.5. The Model with Heterogeneous Operating Costs and Positive Set-up Costs 26 Table 3.4 Heterogeneous Variable Costs: c2 > c1 = 0, β > c2 27 3.6. Conclusions 29 Chapter 4: Branch Deregulation in the US Banking System 30 4.1 Introduction 31 4.2 Situation Before and after 1994 Act 33 4.3 Calculation of efficiency indicators 37 4.3.1 Methodology. 37 4.3.2 Data description 39 4.3.3 Data Envelopment Analysis estimation results 40 4.4 Empirical Model 42 4.4.1 Determinants of Bank Efficiency 42 4.4.2 Bank Bankruptcy Analysis 46 4.5. Conclusions 51 Chapter 5: Lending Practice Outcomes of Large and Small Banks 53 5.1. Introduction 54 5.2 The four Hypothesis about Problem Loans and Efficiency 55 5.3 Review of Bank Lending Practices by bank’s size 57 5.4 Overview of the Banking during 1984-2004 58 5.5. Estimation of the Efficiency 60 5.6. Panel Model 63 5.7. Results 65 5.8 Conclusions 67 Chapter 6: Summary and Concluding Remarks 68 6.1 Summary 68 6.2 Concluding Remarks 69 Appendix 72 vi Figures and Tables Table 4.1: DEA Indicators Summary Results 72 Table 4.2: Intrastate Branching Deregulation by State 73 4.3: Distribution of states by the assigned four regions 74 Table 4.4: Determinants of DEA scores: Pool Estimations 75 Table 4.5: Determinants of Banks Failure: Three year Logit Model 76 Table 4.6: Marginal Effects of the Logit Model. 77 Figure 4.1: A graphical explanation of the DEA 78 Figure 4.2: DEA by Quartiles 78 Figure 4.3: Average DEA scores by states (1984) 79 Figure 4.4 :Average DEA scores by states (1997) 80 Figure 4.5: DEA for Regions 81 Figure 4.6: Intrastate Branching allowed by merger and acquisitions 82 Figure 4.7: Banks by Regions with assets below US100 Mill. 83 Figure 4.8: Number of Failing Banks by Region 83 Figure 4.9: Number of Failing Banks by Size 84 Table 4.7: Definitions and descriptive statistics for the variables employed in the Pool and Logit Model (for the whole period 1984-1997). 85 Figure 5.1: Evolutions of Shares of NPL, Capital and Efficiency 86 Figure 5.2: Size Distribution of Banks in 1990 and 2000 87 Table 5.1: Cost Efficiency Scores. 88 Table 5.2: Granger Causality: NPL/LOAN does not cause Efficiency 89 Table 5.3: Granger Causality: Scores of Efficiency that does not cause NPL/LOAN 92 Table 5.4: Granger Causality: Efficiency scores above average that does not cause NPL/LOAN 95 Table 5.5: Granger Causality: CAPITAL/ASSET does not cause NPL/LOAN 98 Table 5.6: Summary of the Four Hypotheses by size and period of time 101 Table 5.7: Definitions and descriptive statistics for the variables employed in Granger Causality Test (for the whole period 1985-2005). 102 References103 1 Chapter 1 Introduction to the Three Essays on Bank’s Relative Efficiency 2 1.1 Introduction This dissertation presents three essays on banks’ relative efficiency. We calculate two different methodologies to obtain efficiency indicators. We use these efficiency indicators as primary inputs to analyze different aspects of the banking system. Branch Regulation in the US banking system is the first issue in this study. In the last chapter, hypothesis about intertemporal relationships between shares of capital, nonperforming loans and efficiency are discussed with a new methodology to measure efficiency. Here, we include size effects and two time periods. The second chapter presents a review of the situation before and after the enactment of the Riegle Neal Act of 1994. The act released the restriction to open branches. The chapter discusses two different points of view regarding branching restrictions. We also describe some attempts to avoid the restriction to open branches. The chapter is an introduction to the three essays discussed later. The third chapter develops a theoretical model of bank competition. We develop two different scenarios in the model. The scenarios vary depending on whether a bank is allowed to open a branch in another state or not. The main results of the model discuss some of the principal issues presented in the previous and next chapter. The model developed in this chapter is able to explain some important factors that permitted the enactment of the Riegle Neal Act of 1994. The fourth chapter presents an empirical analysis of the effects of banking deregulation. The chapter is a complement to the third chapter. In 1994, as we mentioned, branching restrictions were eliminated for all states in the US. However, many states started to relax branching restrictions during the 80’s. The focus of the chapter is to determine whether this deregulation process affected banks’ efficiency. In addition we run a logit model to evaluate if deregulation affected bank’s failure. 3 The fifth chapter presents an analysis of the intertemporal relationships between shares of capital, nonperforming loans and efficiency. These intertemporal relationships are evaluated by testing four hypotheses about Bad Management, Skimping, Bad Luck and Moral Hazard. We use a different approach to measure efficiency indicators. The methodology is called Cost Efficiency that contrasts with Data Envelopment Analysis technique described in the fourth chapter. The analysis of the intertemporal relationships between shares of capital, nonperforming loans and efficiency complements the seminal paper by Berger and DeYoung (1997). [...]... problem, was considered and refined during four consecutive sessions of Congress In 1933, Congress amended the Act The main changes will be discussed in this chapter 5 2.2 Opponents and the Proponents of Branching There were proponents and opponents of the branching restriction The main discussions are given in Senzel (1992) paper A Portfolio Diversification versus Development of the Community Opponents of... restrictions are still imposed in the formation of branches or the conversion of a bank holding company into a branch in order to prevent bank concentration For instance, a branch cannot have more than 30 percent of the deposits held by insured depository institutions in a particular state, unless the host state eliminates the limitations entirely or has a lower concentration restriction In addition, the... spatial competition model, and sections 2.5 and 2.6 introduce different extensions to the original framework Finally, section 2.7 concludes 3.3 The Model We assume an economy with two banks, 1 and 2, and two regions, A and B Initially, bank 1 exclusively locates in region A and 2 in region B Each region is populated by a mass of investors, which has been normalized to one Investors in each region can borrow... competition) Alternatively, we consider an environment where bank branching restrictions are no longer present Specifically, suppose that bank 1 has the alternative of opening a branch in region B We assume in this section that, for exogenously given reasons, bank 2 still only operates in B.18 Therefore, without branching constraints, bank 1 will choose the best alternative among the following options:... opponents of branching believed that branch banking was based on the theory of market concentration These people say that concentration of resources would reduce competition Opponents of branching also argued that branch banking would gradually eliminate competitors because large banks open branches in small towns and take small banks away from the 6 community The situation is considered by opponents... new markets The rapid growth of BHCs made the Congress became concerned about the possible bank concentration The final outcome of this concern was the imposition of the Bank Holding Company Act of 1956 (BHCA) which regulate the geographic expansion, concentration, and affiliation of BHCs The Douglas Amendment (1956) prohibited to the BHCs the acquisition of an out of state banking subsidiary unless... bank holding company to consolidate its existing network of subsidiary banks into one bank 11 Chapter 3 Spatial Competition between Banks: A Theoretical Model 12 3.1 Introduction The U.S banking industry has undergone in the last thirty years through a long process of deregulation This paper focuses on one aspect of such process: the deregulation of bank branching restrictions In 1927, the McFadden... transportation costs or, in our case, the costs of performing long-distance transactions The organization of the paper is as follows Section 2.2 provides a brief description of the changes implemented in the banking sector in terms of interstate branching restrictions Section 2.3 presents the basic setup Section 2.4 solves the spatial competition model, and section 2.5 extends the original framework to incorporate... banks and setup costs Finally, section 2.6 concludes 9 See, for example, Judd (1985) 15 3.2 Banking Deregulation: Brief Historical Review The discussion about bank branching restrictions in the U.S can be traced back to 1864, when the Congress passed the first major national banking legislation in the United States.10 The National Banking Act of 1864 provided banks (among other things) the alternative... operations The McFadden Act of 1927 applied this principle to branch banking regulation In general, the Act prevented national banks from branching However, they were allowed to establish offices in other sates if and only if a state law permits a state chartered bank to take the same action The McFadden Act was passed by Congress after long debates between opponents and proponents of branching restrictions.11 . Essays on Bank’s Relative Efficiency 2 1.1 Introduction This dissertation presents three essays on banks’ relative efficiency. We calculate two different methodologies to obtain efficiency indicators author. v Table of Contents ABSTRACT ii ACKNOWLEDGEMENTS iv Chapter 1: Introduction to the Three Essays on Bank’s Relative Efficiency 1 1.1 Introduction 2 Chapter 2 :Review of the situation before and. branching deregulation which started in 1970. A discussion between proponents and opponents of branching deregulation is presented. A debate between bank’s efficiency and concentration before Riegle